The present invention is directed to a system and process for specifying a constant-dollar financial instrument and then, step-by-step, primary component-by-primary component, transforming the desired constant-dollar financial instrument into an equivalent nominal-dollar instrument.
In the prior art, there is disclosed processes for specifying a nominal-dollar financial instrument and then adjusting the nominal-dollar financial instrument (in varying degrees) for the impact of inflation. However, such prior art type processes do not achieve the advantages of the present invention. The constant-dollar financial instrument of the present invention make use of the "matching principle" as will be discussed below.
Constant dollar financial instruments are financial instruments whose primary components are defined in terms of constant-dollars. Constant dollars are nominal-dollars, (the dollars of ordinary commerce), adjusted by the use of a price index, thereby eliminating the impact of inflation on the purchasing power of the dollar (i.e., constant-dollars are dollars with constant purchasing power as opposed to constant face value). Nominal dollars are dollars having a constant face value. For example, a one dollar bill is a nominal-dollar. However, two years from now that one dollar, given the effects of inflation, will have a purchasing power of less than one dollar.
The inventors of the present invention have established that the application of the "matching principle" requires the general utilization of constant-dollar financial instruments by providers and users of funds throughout the financial system.
The "matching principle" is a fundamental principle in the area of applied finance that has been the subject of very little academic research. It applies to both users and providers of funds.
For users of funds, the application of the "matching principle" requires that the characteristics of the financial instruments issued by the user of funds should be matched as closely as possible to the characteristics of the investments being financed by the user of funds. For providers of funds, the application of the "matching principle" requires that the characteristics of the financial instrument in which a provider of funds invests should be matched as closely as possible to the characteristics of the liabilities being funded by the provider of funds.
Final users of funds invest in the real productive capital (e.g., plant and equipment, commercial real estate, social infrastructure, etc.) of the economy. These "Real" assets have expected income streams and expected depreciation schedules that are most accurately described in terms of constant dollars as opposed to nominal dollars. This is because their future income streams and depreciation schedules as measured in nominal dollars will vary with unknown future inflation rates, but this variation is eliminated by utilizing constant dollars which are unaffected by future inflation.
The application of the "matching principle" to final users of funds requires that the payment schedule of the instrument match the time pattern of the income stream of the LDB WFP asset being financed and that the amoritization schedule of the instrument match the depreciation schedule of the asset being financed. Since both the income stream and the depreciation schedules of the assets being financed are most accurately defined in terms of constant dollars, both the payment and amortization schedules of the financial instrument must also be defined in terms of constant dollars. Mathematical consistency then requires that the rate of return must also be defined in terms of constant dollars. Therefore, application of the matching principle requires that final users of funds utilize constant-dollar financial instruments to finance their investments in real assets.
Final providers of funds are the actual savers in the economy or their agents. The actual savers in the economy are those who choose to forgo consumption in order to save--i.e., the individual consumers in the economy. The agents of the actual savers are those institutions to whom individual consumers have delegated some part of their saving activity. Pension funds are also the largest and fastest growing agents of actual savers. Pension funds are also the largest and fastest growing source of long-term funds in the economy.
The application of the "matching principle" to final providers of funds requires that the characteristics of the financial instruments in which providers of funds invest should be matched as closely as possible to the characteristics of the liabilities which the providers are funding.
The liabilities that the final providers of funds or their agents are funding include retirement, future educational expenses, and possible future medical expenses. All of these liabilities are "Real" liabilities--i.e., they are much more accurately defined in terms of constant dollars than in terms of nominal dollars because constant dollars are not affected by unknown future inflation. Therefore, application of the "matching principle" to the final providers of funds requires that they fund their "Real" liabilities with constant-dollar financial instruments.
Financial intermediaries stand between the final users of funds and the final providers of funds. Financial intermediaries provide most of the funds utilized by final users of funds and use most of the funds provided by final providers of funds. The final users of funds, the final providers of funds, and financial intermediaries, taken together, make up the general financial system of the economy.
The "matching principle" also applies to financial intermediaries. They must match the characteristics of their assets (the securities issued by final users of funds) to the characteristics of their liabilities (the securities that financial intermediaries issue to final providers of funds). The application of the "matching principle" to the financial system of the economy requires that all of the participants--the final users of funds, the final providers of funds, and the financial intermediaries--all utilize constant-dollar financial instruments.
However, constant-dollar financial instruments are not consistent with present legal and tax statutes. If constant-dollar financial instruments are to be utilized to achieve the benefits that they make possible through effective utilization of the matching principle, then a process is required to transform any desired constant-dollar financial instrument into an equivalent nominal-dollar instrument.